Effects Of The Financial Crisis On Iceland Economics Essay

Effects Of The Financial Crisis On Iceland Economics Essay The country of Iceland is the smallest economy within the Organization for Economic Cooperation and Development (OECD) with a gross domestic product (GDP) in 2007 of about $11.8billion. The Icelandic economy has been based on marine and energy resources. More recently, Iceland has developed a very strong services sector, which accounts for two-thirds of the economic output. Since the start of the decade i.e. from 2000, Iceland has experienced particularly strong growth in its financial services sector. Trade accounts for a large share of Icelands GDP, with imports accounting for 46% in value and exports accounting for 35% in value of goods and services of GDP. Icelands main export item was fish and other marine products until the year 2006, when Iceland began to capitalize on its abundant thermal energy resources to produce and export aluminum. A combination of economic factors over the early to mid-2000s led to Icelands current economic and banking distress. In particular, access to easy credit, a boom in domestic construction that fueled rapid economic growth and a broad deregulation of Icelands financial sector spurred the banks to expand rapidly abroad and eventually played a role in the eventual financial collapse. Iceland benefited from favorable global financial conditions that reduced the cost of credit and a sweeping liberalization of its domestic financial sector that spurred rapid growth and encouraged Icelands banks to spread quickly throughout Europe. The 2008-2010 Icelandic financial crisis was a major ongoing economic crisis in Iceland that involved the collapse of all three of the countrys major banks (Kaupthing, Landsbanki, Glitnir) following their difficulties in refinancing their short-term debt and a run on deposits in the United Kingdom. Relative to the size of its economy, Icelands banking collapse was the largest suffered by any country in economic history of the world. This was the main reason why Iceland had to suffer so much in the crisis. Commenting on the need for emergency measures, Prime Minister Geir Haarde said on 6 October 2008, There [was] a very real danger that the Icelandic economy, in the worst case, could be sucked with the banks into the whirlpool and the result could have been national bankruptcy. He also stated that the actions taken by the government had ensured that the Icelandic state would not actually go bankrupt. At the end of the second quarter 2008, Icelands external debt was 9.553 trillion Icelandic krà ³nur (à ¢Ã¢â‚¬Å¡Ã‚ ¬50 billion), more than 80% of which was held by the banking sector. This value compares with Icelands 2007 gross domestic product of 1.293 trillion krà ³nur (à ¢Ã¢â‚¬Å¡Ã‚ ¬8.5 billion). The assets of the three banks taken under the control of the FME totaled 14.437 trillion krà ³nur at the end of the second quarter 2008. MONETARY POLICY Monetary policy is the process a the government, central bank, or monetary authority of a country uses to control (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory therefore provides insight into how to craft optimal monetary policy. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation. During the financial crisis, Icelands monetary policy credibility had been very seriously damaged. Unsatisfactory inflation outcomes had already undermined the credibility of the monetary framework, even before the financial crisis started and, consequently, inflation expectations were poorly anchored. Icelandic economists had said that due to the huge impact of the crisis, rebuilding the credibility was likely to take time, and also maintaining it might be very difficult. However, after the crisis, the Monetary Policy Committee (MPC) had voted to lower the Central Bank interest rates by 0.5 %. By supporting the interest rate cut, it lead to the appreciation of the krona in trade weighted terms. As in the ISLM Model, a decrease in the interest rates leads to an increase in the money supply. Therefore, this has lead to an expansionary monetary policy, as the interest rates were lowered, and also the MPC supported or voted for lower interest rates. MONETARY POLICY GRAPH The above graph shows the shift in the LM towards right, which has lead to an expansion in the LM curve. Since the MPC voted for a lower interest rates , the money supply was increased. Therefore, the LM curve shifts from LM1 to LM2, leading to an expansionary of the monetary policy. FISCAL POLICY In economics, fiscal policy can be defined as the use of government expenditure and revenue collection to influence the economy. Fiscal policy refers to the overall effect of the budget outcome on economic activity. There are three possible stances of fiscal policy: Neutral stance, which implies a balanced budget where, govt. spending = Tax Revenue Expansionary stance, increase in the govt. spending and reduction in tax revenue Contractionary stance, decrease in the govt. spending and increase in tax revenue During the financial crisis, there was an increased government debt. Due to the recession and rising debt servicing costs, the public deficit was projected to be above 10% of GDP in 2009, adding to the public debt burden. As a result, a considerable fiscal consolidation was therefore needed to put public finances back on a sustainable path and to pave the road for a successful euro-area entry. It was also important to reduce the deficit vigorously in the coming years, so that the country can reach the goal of balance. In order to eliminate the deficit, the government of Iceland had the option of tax increases as well as spending cuts, it then decided to opt for the former as they were easier to introduce immediately. The starting point for the tax increases would have been to reverse tax cuts implemented over the boom years, but Iceland could no longer afford. This would involve the increase in the personal income tax and also lift the reduced rate of VAT (Value Added Tax). This planned fiscal consolidation, would involve measures which would help to contain the expenditures. FISCAL POLICY GRAPH The above graph, shows the shift in the IS curve towards left, which leads to the contraction of the IS curve. Since the govt. decided to reduce their expenditure and increase the taxation, in order to consolidate the fiscal policy, the IS has moved towards left, leading to an contractionary fiscal policy. INFLATION In economics, inflation can be defined as the rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, then each unit of currency buys fewer goods and services; consequently, annual inflation is also erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy. The effects of inflation on an economy are manifold and can have both simultaneously positive and negative impacts. Since Iceland, comes from a small domestic market, the banks in Iceland have financed their expansion from getting loans on the inter-bank lending market and, more recently, by getting deposits from outside Iceland (which are also a form of external debt). Large amount of debt was also taken by the households, which was equivalent to 213% of the disposable income, causing inflation in the country. Due to the practice of the Central Bank of Iceland issuing loans (liquidity) to the different banks on the basis of uncovered bonds which are newly issued and printing money on demand, this lead to inflation being exacerbated. Due to the financial crisis, the country of Iceland suffered inflation. On 25th of March 2008, popular website, Bloomberg.com that Iceland had raised its rates to 15% by raising its repo rate by a huge 1.25% in one day. The website also reported that the country was facing an inflation rate of about 7%. However, the Central Bank of Iceland had a goal of maintaining the inflation rate of about 2.5%. Also the Icelandic currency, krona has declined against the euro, from about 100 ISK per euro at the beginning of the year (2008), to its nadir of 125 on March 19 2008. Due to the interest rate hike it had the effect of moving it to about 116 from about 122. In August 2006, the country of Iceland made news when it had increased its interest rate to 13.5%. At that time, the krona was very strong against the euro. Iceland made news previously in August, 2006 when it increased its interest rate to 13.5%. The krona was then trading at a stronger at 90 to one euro. Some main factors why Iceland incurred inflation was mainly due to, the value of krona depreciated, secondly the prices of various commodities kept on soaring, and lastly, there was uncertain effect on wage agreements on labour costs. Since the financial crisis brought a huge change in the development of the economies in the world, as well as making many banks go bankrupt, the Icelandic debt is now over 320 billion krona, which is roughly about $4 billion US dollars. This figure is huge; as one can say considering that its about a quarter of their GDP. INFLATION GRAPH Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2010 6.60 7.30 8.50 2009 18.60 17.58 15.19 11.89 11.63 12.18 11.32 10.90 10.81 9.71 8.63 7.50 2008 5.77 6.79 8.72 11.76 12.32 12.74 13.55 14.54 14.02 15.89 17.15 18.13 2007 6.89 7.41 5.87 5.29 4.67 4.01 3.76 3.45 4.18 4.47 5.19 5.86 The above graph shows Icelandic inflation rate over the past 3 years. In the graph, one can make out how the inflation rate climbed up consistently in the year 2008, whereas in the year 2009, the inflation rates kept on falling except in the month of June where it increased, but since then it had kept on decreasing. In the year 2008, the reason why inflation rate climbed up consistently, was because of the krona which had been depreciating, where as in the year 2009, the inflation rates kept on falling as the property prices fell, which resulted in the fall of prices. UNEMPLOYMENT Unemployment can be defined as people who do not have a job, have actively looked for work in the past four weeks, and are currently available for work. Also, people who were temporarily laid off and are waiting to be called back to that job are counted as unemployed. Some types of unemployment are listed below: Structural Unemployment. Frictional Unemployment. Cyclical Unemployment. Since the financial crisis, lead to large percentage of unemployment all over the world, Iceland was also one of them which had a quite high rate of unemployment. Unemployment in Iceland increased tree times more by the end of November 2008. There were more than 7000 registered jobseekers (about 4% of the workforce) in November compared to just 2136 at the end of August 2008. The debt repayment had become more costly as household debt (80%) and 13% denominated in foreign currencies had become indexed. The impact of the crisis was such that since October 2008, 14% of the total workforce had experienced reductions in pay, whereas around 7% of the workforce had their working hours reduced. According to IFL (Icelandic Federation of Labour) president Gylfi Arnbjà ¶rnsson, the above figures were lower than expected More than 85% of the workforce who were currently registered as unemployed in the country, stated that they had become unemployed or lost their jobs in October after that, due to the economic collapse. In December 2008, the unemployed figures which were registered in Iceland was 4.8 per cent, or around 7,902 people an increase of some 45 percent in November, according to the figures from the Directorate of Labour. These unemployment figures were the highest, Iceland had recorded since January 1997. In the same month i.e. December in the year 2007, unemployment rate partly was 0.8 percent, or 1.357 people. The Directorate of Labour had estimated that the figure will rise to 6.4-6.9 percent by the end of January 2009. Among those unemployed, the rate of unemployment among young people had increased the fastest, with the number of registered 16 to 24 year olds jumping from 1,408 to 2,069 in the month to the end of December 2008. This age group accounts for 23 percent of the entire jobless total. UNEMPLOYMENT GRAPH 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 2003 2004 2005 2006 2007 2008 2009 2010 The above graph shows the rate of unemployment over the past 7 years. During the financial crisis, the rates skyrocketed especially in the year 2010, due to the banking as well as financial collapse. Many became jobless as banks and other sectors were closed. Other reason why the rate was high in 2010 was, because the fishing sector was affected. This sector accounts for 10% of the total workforce in the country. GROSS DOMESTIC PRODUCT The Gross Domestic Product (GDP) is defined in economics as a basic measure of a countrys overall economic output. It is the market value of all final goods and services made within the borders of a country in a year. It is often positively correlated with the standard of living, though its use as a stand-in for measuring the standard of living has come under increasing criticism and many countries are actively exploring alternative measures to GDP for that purpose. The Gross Domestic Product (GDP) can be determined in three ways, all of which should in principle give the same result. They are the product (or output) approach, the income approach, and the expenditure approach. Prior to the 2008-2010 crises, the economy of Iceland had achieved high growth, also had a low rate of unemployment, and a remarkably even distribution of income all over the country. The economy depended heavily on the fishing industry which is the main source of their income, which provides 70% of export earnings and employs 10% of the work force. Icelands economy had been diversifying into manufacturing and service industries in the last decade, with new developments in software production, biotechnology, and tourism. During the global financial crisis, the crisis-stricken Icelandic economys GDP shrank by a record 6.5% in 2009, despite having a decent growth of 1% in 2008 and massive growth of 6% in 2007. The decrease in the gross domestic product (GDP) by 6.5% was a record in the national accounts of Iceland. There was a sharp decline in GDP in last year (2009) as the domestic expenditure plunged by 20.1%, then the household consumption also fell to 14.6% due to unemployment and government consumption dwindled by 3%. Also, Icelands fixed capital formation dropped by 49.9%. These were the reasons why the gross domestic product (GDP) fell by a huge margin, in the year 2009. After the crisis, the Gross Domestic Product (GDP) in Iceland managed to expand at an annual rate of 3.30 percent in the last quarter i.e. in the year 2009. Iceland Gross Domestic Product is now worth 17 billion dollars or 0.03% of the world economy, according to the World Bank. Icelands Scandinavian-type social-market economy combines a capitalist structure and free-market principles with an extensive welfare system, including generous housing subsidies. GROSS DOMESTIC PRODUCT (GDP) GRAPH Year Mar Jun Sep Dec Average 2009 -5.10 -0.40 -7.20 3.30 -2.35 2008 2.90 -6.00 1.80 3.20 0.48 2007 2.10 0.80 5.10 -1.00 1.75 The above graph, describes the changes in the gross domestic product (GDP) of Iceland over the past 3 years. During the years 2007 2008, Iceland recorded a growth in the GDP, which helped in boosting the Icelandic economy. However, most of the year in 2009, it recorded a huge decline of 6.5%, except in the last quarter i.e. in the month of December where it a recorded a positive GDP. The main reasons why the GDP declined in the year 2009 was because the household consumption, the government consumption, as well the domestic expenditure rate had fallen massively, resulting in a negative GDP for the most part of the year. CURRENCY The Iceland currency which is known as krà ³na had been declined more than 35% against the euro from January to September 2008.Inflation of consumer prices was running at 14% and Icelands interest rates had been raised to 15.5% to deal with the high inflation. In the month of October 2008, the effects of financial crisis brought about a collapse in the Icelandic banking sector. The Central Bank of Iceland abandoned its attempt to peg the Icelandic krà ³na at 131 krà ³nur to the euro after it had tried to set this peg in the month. During the month, the Icelandic krà ³na was trading at 340 to the euro when trading in the currency had collapsed because the last major Icelandic bank had been takeover by the FME and thus the loss of all krà ³na trade clearing houses. Then, the central bank introduced restrictions on the purchase of foreign currency within Iceland. From October to November, the European Central Bank quoted a reference rate of 305 krà ³nur to the euro. The Central Bank of Iceland had then set up a temporary system of daily currency auctions in the month of October to facilitate international trade. The value of the krà ³na was determined by supply and demand which took place in these auctions. The first auction sold à ¢Ã¢â‚¬Å¡Ã‚ ¬25 million at a rate of 150 krà ³nur to the euro. Commercial krà ³na trading outside Iceland had again been started in the end of October, at an exchange rate of 240 krà ³nur to the euro, after which Icelandic interest rates had been raised to 18%. The foreign exchange reserves of the Central Bank of Iceland had felled by US$289 million during the month of October 2008. During November 2008, the real exchange rate (discounting inflation) of the Icelandic krà ³na, which was quoted by the Central Bank of Iceland, was approximately one-third lesser than the average rate from the period 1980-2008, and also 20% lower than the historical lows during the same period. The external rate which was quoted by the European Central Bank was still lower. On the last trading day of the month November, the Central Bank of Iceland had quoted 182.5 krà ³nur to the euro, while the European Central Bank had quoted 280 krà ³nur to the euro. INTERNATIONAL TRADE The economy of Iceland is small and subject to high volatility. Icelands standard of living is among the worlds highest, in part due to the overall openness of its economy, which has allowed Iceland to reap significant benefits from specialization and trade according to a report on the trade policies and practices of Iceland published by the WTO Secretariat. Iceland has a mixed economy with high levels of free trade and government intervention. Iceland has a free market economy with relatively low taxes compared with other OECD countries. However, government consumption is less than in other Nordic countries. Icelands trade policy is pursued along three main tracks: multilateral trade liberalisation through the WTO, regional liberalisation through the European Economic Area (EEA) with its EFTA/EEA partners and the European Union and finally, bilateral free trade agreements in cooperation with its EFTA partners Norway, Liechtenstein and Switzerland. Icelands international treaties hav e strengthened foreign trade. The EEA Agreement covers the free movement of goods, persons, capital and services. Membership in the EEA in 1994 and the Uruguay Round agreement brought greater market access for Icelands exports, capital, labor, and goods and services, especially seafood products. Agriculture is heavily subsidized and protected by the government, with some tariffs ranging as high as 700 percent. Iceland is a part of the World Trade Organisation (WTO). The WTO was established on the 1st of January 1995. It is an organization designed to supervise and liberalize international trade. Since the early 1990s, Iceland and its other partners in the European Free Trade Association (EFTA) Liechtenstein, Norway and Switzerland have established an extensive network of contractual free trade relations in Central and Eastern Europe, the Mediterranean region and with countries in other parts of the world. The WTO deals with controlling of trade between participating countries; it provides a framework for negotiating trade agreements. The country has signed a large number of multilateral and bilateral agreements. Iceland is furthermore strongly committed to the Doha Development Agenda and a fair and equitable outcome that will benefit the entire membership. Iceland supports the Doha Development Agenda Global Trust Fund, which is intended to assist developing countries in taking advantage of the opportunities created by increased trade liberalization. Iceland exports 40% of fish and fish products, 40% of aluminum and alloys and animal products. The main imports are machinery and equipment, petroleum products, foodstuffs and textiles and Cement. Icelands primary import partner is Germany, with 12.6%, followed by the United States, Norway, and Denmark. Currently, the largest trading partner countries are Germany, the UK, the Netherlands and the Nordic countries. The fishing industry is one of the most important industries. It provides 70% of export income and employs 6.0% of the workforce; therefore, the state of the economy remains sensitive to world prices for fish products.  [i]  The diversity of Icelands exports has, however, increased significantly in recent years, due to structural reforms and privatisation of state owned entities in finance and other sectors. Exports of manufactured products have been growing rapidly. Services now account for 36% of total export revenues while in 1990 the share was 26%. Icelands ratio of services to total trade is one of the highest among OECD countries. It is the Governments stated objective to provide Icelandic agriculture with a realistic opportunity to adapt to changes in its operating environment, to the benefit of farmers and consumers alike. The growth of international trade had been affected in the 1930s by the existence of tariffs and other barriers to international trade. To avoid such problems an agreement, the general Agreement of Trade and Tariffs, was concluded between 44 countries which included Iceland. Iceland joined GATT in 1968. GATT stated that an international agreement should be created which required a binding code of conduct for international trade; its main objective was the liberalization of world trade. Its principle was that there would be mutual benefits if international trade took place on the basis of non-discrimination and should be gradually reduced through negotiations. The liberalization for international trade gave Iceland confidence in their trade. During the period 2003-07, Iceland developed from a nation best known for its fishing industry into a country providing sophisticated financial services, but was consequently hit particularly hard by the 2008 global financial crisis, which extended into 2009.  [ii]   Self-protection and self-preservation have characterized Icelands foreign trade policy since its independence from Denmark. While Iceland is a highly developed country, until the 20th century, it was among the poorest countries in Western Europe. However, strong economic growth has led Iceland to be ranked first in the United Nations Human Development Index report for 2007/2008.  [iii]   TARIFF Iceland enjoys some of the strongest economic freedoms among all countries However; Iceland is very isolationist as regards to the import of farm products and licenses as well as state monopolies of imports (undergoing a dismantling). Some plant products such as potatoes and flowers are subject to seasonal limitations. Iceland implements high tariffs on agricultural products in order to protect the domestic agricultural sector. Tariffs on certain varieties of vegetables, e.g. tomatoes, cucumbers and bell peppers are significantly higher during the growing season to protect domestic greenhouse producers. Meat and dairy products, and potatoes are also protected by substantial duties. Animal feed can carry tariffs up to 55%. Over 90% of imports are not subject to import restrictions or duties other than the same value-added tax applied to domestically produced goods. Special excise taxes are levied on sugar and some sugar products, potatoes, and motor vehicles. Agricultural products remain the most heavily taxed. In March 1970, Iceland acquired full membership in EFTA. On 28 February 1973, Iceland ratified a trade agreement with the European Community (later named the European Union) leading to the elimination of tariffs on industrial goods. A law authorizing the establishment of free trade zones went into effect in 1992. Icelands trade regime underwent considerable liberalization in the 1990s with accession to the European Economic Area (EEA) in 1993, and the Uruguay Round in 1994. Current duty rates generally range from 0% to 30% ad valorem and the average weighted tariff is 3.6%. Some goods enter duty-free, such as meat, fish, and dairy products. Icelands average MFN applied tariff is 5.9%. A high percentage of tariff lines (70%) benefit from duty free treatment. The average MFN applied tariff rate  for agricultural products is 18.3% (WTO definition) compared with 2.5% for other goods.  [iv]   Iceland offers preferential tariffs on imports from 37 WTO Members under several free-trade agreements. Regional liberalization has advanced the most within the framework of the European Economic Area (EEA); nonetheless, the average tariff on products from EEA partners is still 3.2%, reflecting the exclusion of several agricultural products from duty-free treatment. A new Customs Law came into force on 1 January 2006 (Act No. 88/2005). According to the authorities, customs clearance for all importation aspects is computerized; electronic data interchange (EDI) covers 98% of the declarations of import and export firms. Customs clearance using EDI takes a matter of minutes, or a few hours if processed manually. CONCLUSION The occurrence of the financial and economic crisis left economists and policymakers wondering about its causes. A vast majority of economist and policymakers blamed the free-market reforms. At the beginning of 1990s, the government of Iceland implemented a set of free-market reforms under the leadership of David Oddsson. The companies own by the state were privatized. Financial markets were liberalized. The central bank was granted full independence in refining extensive inflation. Also, the corporate tax rate was cut from 52 percent in 1985 to 15 percent in 2008. When the financial crisis battered the stock market which led to the breakdown of the banking sector, many economists, analysts and policymakers immediately blamed free-market reforms as the foremost origin of the crisis. However, the empirical evidence and a macroeconomic analysis reverse this kind of thinking. The main origin of the financial and economic crisis that evolved in Iceland is a failure of monetary policy. In 2002, Iceland witnessed a mild recession that ended quickly. Ever since then, the central bank constantly failed to meet the inflation target. In response, it raised benchmark interest rate to double-digit levels. As a consequence of a stunning gap in interest rates, the Icelandic krona strongly appreciated. In such circumstances, high domestic interest rates discouraged the domestic banking sector from borrowing in domestic currency. With interest rates standing at double-digit levels, uncovered interest parity encouraged households, firms and banks to borrow in foreign currency. Iceland has been a part of the news lately because of the recent volcanic eruptions which took place on 15th April 2010 in the glacier Eyjafjallajokull in South Iceland. Day to day business in Iceland apart from the directly affected areas in the south has not been affected. The ash hurled into the atmosphere by the eruption has however caused serious disruption of air traffic due to which number of flights have been cancelled and also heavy losses has been incurred to the aviation sector, especially in UK.